3/05/2009 @ 12:00AM

Why The Bailout Is Self-Defeating

Under the Financial Stability Plan (the bailout formerly known as TARP), the Treasury Department gave nearly $350 billion, and is soon to give another $100 billion, to the banking industry in exchange for shares in participating banks.

This deal was intended to bolster public confidence in banks, while at the same time minimizing the cost of the bailout when Treasury sells its shares once markets pick up. The form of equity Treasury has taken, and plans to take in the second round of the bailout, threatens to destroy both goals.

This is because governments have two unique qualities: immunity from insider trading laws and a political interest in using their shareholder power to pander to special interests.

A healthy share price makes for a healthy bank. But healthy share prices require healthy profits. When governments become powerful shareholders in companies, the profit motive is inevitably watered down.

After European governments privatized government-run industries in the 1980s they maintained powerful equity positions in the privatized firms. Those companies were twice as likely to need to subsequently obtain subsidies and bailouts at the public trough.

The Treasury’s preferred shares are a first, stealthy step toward bank nationalization. Treasury gave up ordinary voting rights in its shares, but not in all cases, and it kept the right to vote to block tender offers.

Even worse, the Obama administration is discussing taking preferred shares convertible into voting common equity as part of the second round of the bailout. U.S. Treasury Secretary Tim Geithner has now converted Treasury’s Citigroup shares into enough voting common equity to gain complete control over the bank.

Outright bank nationalization is the only nail left to drive into the coffin. In some ways, that would be preferable to the effective nationalization of holding a control stake. At least then the bank would be on the federal budget. If you think the government stuffs pork into its budget, wait until Treasury gets its hands into the budgets of private banks unencumbered by the federal budget process and those pesky separation-of-powers restraints.

This is not the first time the U.S. government has been given influence to choose directors in publicly traded companies. We have two recent examples to learn from: Fannie Mae and Freddie Mac. For better or worse (and as former Freddie Mac Director Rahm Emmanuel knows), the federal government encouraged Fannie and Freddie not to let silly notions like revenue and profits get in the way of backing unaffordable mortgages for home buyers. Why? Because home buyers vote.

It wasn’t just Fannie and Freddie steering the ship into the financial maelstrom. But after the past two years we should finally appreciate that governments shouldn’t regulate businesses and participate in them. Fannie and Freddie were two companies. The Treasury now owns stakes in over 200 banks.

A new financial instrument that may fix this mess is something I call a “frozen option.” This would be a long-term option, issued to the U.S. Treasury, to purchase common equity that only non-governmental investors could ever exercise. As long as Treasury held the options they would remain frozen, but as soon as Treasury sold them they could be exercised by the subsequent purchaser.

Another important consequence of the bailout is that Treasury’s access as a regulator to inside information about banks makes it the ultimate inside trader of stocks in financial institutions. Luckily for the federal government, it has sovereign immunity from insider trading laws.

The market will significantly discount the value of banks in which Treasury is a shareholder. Since the dominant player in that market has the opportunity to engage in insider trading, it makes little economic sense for other investors to buy bank shares. Why would anyone want to play the game when they know the game is rigged?

To protect against insider trading liability, corporate executives file “10b-5 plans” that detail future share sales. Treasury should be bound to the same kind of plan to assure investors that it will not use inside information to trade its shares.

Giving government equity upside as part of a bailout dilutes the interest of equity holders, imposing a penalty on them for investing in a business that needed rescue. Bank equity holders are forewarned: Invest more resources to monitor the business decisions of your investments, or else.

But there are many ways to participate in the upside of a company. If you let Treasury choose the method, it will inevitably reach for the one with the most political power. Frozen options, subject to a multiyear binding sales plan to prevent insider trading, are the best way to limit these challenges to the bailout.

J.W. Verret is an assistant professor at George Mason University School of Law and a senior scholar in the Mercatus Center Financial Markets Working Group. This article is based on his recent briefings before the Securities and Exchange Commission and Congress, summarized here.